Early economic theory states that decisions made by humans are rational and based on all available information. It also infers that we will choose the option which gives us the most happiness taking into account our limited resources. However, these economic theories have come into question as evidence is mounting that the decision making models based on these theories don’t actually work in reality. And this is no more apparent than when looking at the reasons why we hold on to some investments and sell others.
Have you ever avoided selling a losing stock in the hope that the company will turn around and see an increase in their share price? I see this in action as an advisor. Many people will not sell a shareholding if it is in a loss position. Why? For a couple of reasons. Firstly, we don’t like losing. We tend to feel losses a great deal more than we do gains. Think about it for a moment. If you find $10 in the street, happy days. Put it in your pocket and go on your merry way not giving a second thought to it. If you were the one who lost $10 in the street, you would retrace your steps and try to remember where you lost it. You would feel this loss more and would agonise over it. Another reason we hold on to those losers (and I am talking about shareholdings here) is due to regret. You may regret that you made a bad investment decision. And by selling at a loss, you are acknowledging this – ouch! It is a negative emotion. And not a particularly productive one in this sense. Why hold on to a company that is losing value in the hope that it will recover one day? Some companies may, but how long are you willing to wait?
We need to take the emotion out of it and base our decision on fundamental facts. Take AMP for example. Their share price fell after their stellar performance at the Royal Commission. But many investors held on because if they sold they would be realising a loss. The fundamentals of the company had changed, their future levels of profitability were under question, however, as a loss would have been realised on the sale, some investors decided to hold. Hindsight is a wonderful thing – but if you would have taken a pragmatic view of their situation, the potential fallout from those revelations, you may have come to a different conclusion. And yesterday is my case and point, AMP lost another 25% off their share price. This was due to announcements made in regard to the sale of part of the business but also to the decline in cashflows within the wealth business to the tune of $1.5 billion – yes, billion. And why did this happen? One reason – the reputational damage done during the Royal Commission. So those investors who held on in hope – well…….. Meanwhile, those that did sell have been able to use the funds to invest in other opportunities – or perhaps even buy back in at much lower prices. The same happened with BHP a few years ago. And I am sure there are many others. Sometimes we need to have the courage to cut our losses and move on. We are not always going to get it right, but when we get it wrong, acknowledge it and move on to better things.